Wednesday, December 10, 2008

We continue to believe that it is too early to buy Canadian banks based on: (1) an economic environment that continues to deteriorate rapidly, (2) increased risk over the sustainability of some banks' current dividends and increased risk of equity issues (both of which are a function of the deteriorating economy and continuing capital markets writedowns), a scenario we would have viewed as highly unlikely only a few months ago, (3) our belief that the street needs to lower its profitability estimates (our EPS estimates are currently 7% below the street's) to reflect the rapidly slowing economy and credit/funding markets that remain challenged.

• Valuations have come down for bank stocks but for them to rally on a sustainable basis, we believe that signs of improvement in the banks' fundamental outlook are needed.

• We have gradually increased our loan loss estimates in recent quarters and have consistently reduced our P/BV multiples to reflect a worsening economy. The economy continues to worsen as highlighted by Friday's employment reports in both Canada and the United States. As a result, we have lowered our 12-month target prices again.

The likelihood of capital raises or dividend cuts for Canadian banks has risen in the last months, in our view.

• Q4/08 writedowns have proven larger than we anticipated, which, combined with growth in risk weighted assets that was faster than we were looking for, has led to lower than expected capital ratios.

• TD, Royal Bank and Scotiabank had lower Tier 1 ratios as at Q4/08 although there was no clear outlier as there was before TD raised equity. National Bank and TD had lower tangible equity ratios as at Q4/08.

• Over the next three months, we expect Scotiabank to face the most pressure to raise capital. It has room to issue meaningful amounts of innovative Tier 1 capital (Scotiabank has a tangible common equity ratio at the high end of the peer group) but we do not believe that the market is as liquid as it would be for common equity.

• We believe TD might be pressured to raise capital again if Scotiabank raises equity as it would again find itself as the clear outlier from a capital standpoint.

We expect 2009 earnings per share to again come short of consensus estimates.

• Our current EPS estimates are a median 7% below consensus.

• Directionally, we feel that there is downside risk to our EPS estimates as (1) economic risks have risen, and (2) the risk of equity issues has risen.

• BMO's target price is cut to $35 from $38• CIBC's target price is cut to $52 from $53• National Bank's target price is cut to $43 from $46• Scotiabank's target price is cut to $33 from $36• TD Bank's target price is cut to $43 from $48

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Dow Jones Newswires, 10 Deceber 2008

The likelihood of a Canadian bank cutting its dividend is very slim, BMO Capital Markets says. Dividends survived the 1981-82 and 1990-91 recessions, the collapse of Third World loans and the collapse of commercial real estate. The Big Five - Bank of Montreal (BMO), Toronto-Dominion Bank (TD), Royal Bank of Canada (RY), Bank of Nova Scotia (BNS) and Canadian Imperial Bank of Commerce (CM) - haven't cut dividends since the Great Depression, BMO says. But analysts suggests the banks should reintroduce dividend reinvestment programs (DRIPs), which could generate C$3-4B in common equity, boosting capital levels.

Bank of Nova Scotia (BNS) likely to be next Canadian bank to issue equity, as the banks scramble to get Tier 1 Capital ratios above 10%. Following RBC's (RY) C$2.3B offer, BNS now has lowest ratio of peers. Credit Suisse suggests it needs C$2.3B in common equity to get to 10%, while Toronto- Dominion (TD) needs another C$1.98B even after last week's issue; Bank of Montreal (BMO) needs C$425M and National Bank of Canada (NA.T) needs C$3.27M. CIBC (CM), which raised C$2.9B in January after taking huge charges, remains in top spot with Tier 1 ratio of 10.5%

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Financial Post, Eoin Callan And Gary Marr, 10 December 2008

Bay Street's profit margins are starting to come under pressure as official interest rates creep closer to zero, prompting retail banks to change the rules of the game so customers pay more.

While the Bank of Canada yesterday cut interest rates to the lowest level since the 1950s, the country's five big banks indicated they would no longer march in lock step with the central bank.

Instead, Bay Street is keeping the cost of borrowing for consumers more elevated in a bid to protect corporate earnings, passing on only part of the rate cut to customers.

While the decision of Bay Street to pocket part of the Bank of Canada rate cut is seen as good for shareholders and bad for customers, there is less certainty about how it will impact wider demand, partly because there are few historical precedents.

"We just don't have much experience with this," said an official at the Federal Reserve who has studied how financial institutions behave when central banks cut rates close to zero.

The central banker said data were limited, but suggest retail banks remain willing to lend even when official rates fall near zero, as they tend to find ways to protect profit margins on loans.

In normal times, financial institutions do better when the central bank lowers the cost of funds, happily passing on cheaper loan rates to consumers to encourage them to borrow more. But when the official rate starts getting closer to zero, the dynamics start to change, as the prime rate that banks charge customers is pushed nearer to their own cost of funds.

This was key to yesterday's decision by RBC, TD, Scotiabank, BMO and CIBC to cut their prime rate by 50 basis points instead of the full Bank of Canada cut of 75 basis points, according to people in the industry.

Joan Dal Bianco, vice-president of real estate-secured lending with TD Bank, said it would have left the bank without a profit if the full rate cut had been passed on to customers with variable products tied to prime.

"We are still trying to earn something on this stuff. This has been quite the roller-coaster ride and it has not been too hot on the mortgage front. We just can't take on the whole 75-point cut," Ms. Dal Bianco said.

Nancy Hughes-Anthony, head of the Canadian Bankers Association, acknowledged the decision to break step with the Bank of Canada created a public-relations challenge for Bay Street.

But she said: "The banks are still borrowing in a very volatile marketplace. The Bank of Canada rate is only one component of their cost of funding, and while the cost of borrowing in inter-national markets has come down a bit, it is still higher than before the crisis."

John Aiken, an analyst at Dundee Securities, said banks were "starting to see margin compression" as the central bank cut rates to 1.5% from 2.25%, while banks reduced their prime lending rate to 3.5% from 4%.

"The new loans that are being put in the books are arguably at a less profitable rate," he said.

Vince Gaetano, a vice-president with Monster Mortgage, said he expects pressure will start to mount on the banks in the coming weeks to reduce prime further.

"That's what happened the last time they tried to resist rate cuts," he said.

This willingness to pass on rate cuts is critical to determining the ability of the Bank of Canada to stimulate the economy in the midst of a downturn.

The central bank's own research shows "it is the real rate of interest that is most relevant" to the purchasing decisions of households, and that it can "influence demand only to the extent that adjustments to the [official] interest rate feed through to the real interest rate."

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Financial Post, Jonathan Ratner, 9 December 2008

When it comes to Tier 1 capital ratios at Canada’s biggest banks, it looks like 10% is the new 9%.

On Monday, Royal Bank announced that it is issuing $2-billion in common equity at $35.25 per share, which represents a 6% discount to its closing price, as well as an over-allotment for maximum proceeds of $2.3-billion. The issue is expected to be approximately 4% dilute to common shareholders.

It will also bring the bank’s Tier 1 capital ratio to 10.1%, up from 9.0% at the end of the fourth quarter as a result of its recently-issued $525-million in preferred shares and this $2.3-billion.

Credit Suisse analyst Jim Bantis expects other banks will follow RBC’s lead, noting a few weeks ago that the Tier 1 capital levels of Canadian banks were among the highest of their global peers at 9.7%. Since then, banks in the United States and Europe have received capital injections via government initiatives and dilutive stock offerings, bringing their Tier 1 ratios into the low double-digits.

He noted that RBC management acknowledged that the offering was driven by investor concerns regarding the need for a stronger capital base given the challenges associated with market conditions.

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TD Securities, 8 December 2008

The underlying results of Q4/08 were not that bad relative to our expectations for one of the worst quarters in a very long time. However, visibility into 2009 is extremely poor and management teams were universal in their cautious tone on the near-term outlook. As a result we further reduced our 2009 estimates and cut our Target Prices which reflect a wider discount to our estimates of equity fair value.

Fundamentals continue to suggest attractive upside across the group 12-16 months out, but we expect fears/concerns to continue to dominate short-term movements amid broader equity market weakness and volatility. Against that back drop we remain focused on names that we believe have the strongest medium term operating platforms that we want to own for the long term (Scotia) or heavily discounted valuations with fairly clean stories (CIBC).

Q4/08 met expectations by delivering one of the worst quarters the group has reported in a very long time, filled with a number of negative surprises.

As we suspected, the group appears to have used Q4/08 reporting as an opportunity to clean-up their exposures with a range of charges. Further downside risks will remain highly market dependent, and we do expect more, but with the help of new accounting flexibility we believe the acute risk presented by significant and immediate write-downs (i.e. those that would impair the capital structure) is greatly reduced. Ultimately we believe the industry will be in a position to enjoy substantial write-backs.

In terms of operating outlook, the credit cycle remains the dominant theme for the industry and will present a significant headwind for earnings in 2009. We further reduced our estimates across the board coming out of the quarter reflecting even greater conservatism on our outlook for credit costs in 2009. Our outlook is now reflecting a move to levels of credit expense comfortably above historical averages (taking into account today’s higher quality portfolio mix) on the order of 60bp. Where there is meaningful exposure, U.S credit books remain the key concern relative to trends within Canada where exposures appear well managed.

On the basis of our revised earnings expectations, 2008 and 2009 will represent among the two worst years of earnings development the industry has reported since the 1960s (as far back as our data set extends).

It is a long ways out, but we are introducing 2010 numbers driven by our bigger picture views of how the environment will unfold. Simply put, under the expectation that the macro environment will be in recovery and credit cost growth will moderate, the industry should be able to return to modest bottom-line growth.

What we viewed as exceptional capital levels just months ago, now appear very ordinary as a number of financial institutions globally have attracted sizeable capital infusions, including a sizeable portion from their respective governments.

In terms of the regulatory environment, in our discussions we have noted increased comments among senior management regarding the prospect of direct capital investment by the Canadian government (heightened by recent government proposals to allow such flexibility). At this stage, our view is that the discussions reflect an effort to anticipate worst case scenarios and provide solutions proactively. For the most part the banks seem disinclined to accept such investments, but they are also mindful of the competitive reality that has seen many of their global competitors accept similar support.

Valuations have come under material pressure over the past month amid continued concern and weakness in global equity markets. In our view the group is currently trading at material discounts to equity fair values implied by assumptions around long term fundamentals (assuming the world eventually recovers from among the worst economic conditions seen in decades). That said, amid very poor visibility generally and the heightened risk of unforeseen problems within financials we continue to expect volatility near-term.

Against that backdrop, we are focused on names that we believe have the strongest fundamental platforms that are well situated to perform when we eventually make it to the upside of the current downturn. In our view, Scotia is a platform well suited for medium-term growth via their international presence, although they are therefore more exposed to the current downturn.

For a shorter term focus, we highlight CIBC where we believe the model has been materially discounted even based on fairly modest operating results for 2009, there is an attractive dividend yield and the overhang of concerns around the bank’s capital position (relative to risks/exposures) is beginning to fade. We expect additional charges in the coming quarters if credit markets remain under-pressure (on the order of few hundred million) which should be easily tolerated by the bank’s industry leading 10.5% Tier 1 ratio in the context of ongoing earnings generation. With this report we are upgrading CIBC to the Action List.

With this report we have also made additional changes to our Target Price for both BMO and National Bank; reducing both targets to reflect additional conservatism around our valuations (assuming the stocks trade at a wider discount to fair value).

• BMO's target price is cut to $40 from $50• CIBC's target price is cut to $67 from $76• National Bank's target price is cut to $50 from $62• RBC's target price is cut to $40 from $55• Scotiabank's target price is cut to $45 from $54

• Royal Bank (RY) cash operating earnings were flat at $1.01 per share slightly better than pre-released numbers. Operating ROE was 20.0% versus 22.9% a year earlier. Reported earnings were $0.84 per share after writedowns with ROE a solid 16.3%.

• Positives this quarter were operating results in Canadian Banking and RBC Capital Markets with negatives being gross impaired loans and credit losses especially in U.S. home builder portfolio.

• Reported earnings of $0.84 per share included net writedowns of $242 million after-tax or $0.18 per share, gains on CDS hedging corporate loan book of $105 million after-tax or $0.08 per share, and a general provision of $145 million ($98 million after-tax or $0.07 per share). Reported ROE for fiscal 2008 was solid at 18.2%.

• Earnings were driven by strong Canadian Banking earnings which increased 11% YOY followed by 16% growth at RBC Capital Markets (excluding writedowns) with Insurance increasing 36% to $139 million. Wealth Management earnings declined 10%. The operating performance in the U.S. was disappointing as earnings declined to a loss of $13 million (excluding writedowns) from net income of $36 million a year earlier due to higher loan loss provisions.

• Mutual fund revenue increased 4% from a year earlier to $387 million. Mutual Fund assets (IFIC) declined 9% from a year earlier to $93.2 billion including PH&N.

• Wealth Management earnings for fiscal 2008 declined modestly to $739 million from $784 million in fiscal 2007.

U.S. & International Banking Records a Loss

• U.S. & International recorded a loss of $13 million versus net income of $36 million a year earlier due to a 175% increase in loan loss provisions. LLPs continued to rise, increasing to $198 million from $72 million a year earlier and up from $137 million in the previous quarter, relating primarily to U.S. residential builder finance. LLPs are at an extremely high levels of 2.32% of loans.

• Security gains were a loss of $15 million or $0.01 per share versus nil per share in the previous quarter and a loss of $0.01 per share a year earlier.

• Unrealized security surplus was a deficit of $1,729 million versus a deficit of $546 million in the previous quarter and a surplus of $105 million a year earlier.

• RY reclassified its $6.9 billion in securities including U.S. auction rate securities and U.S. agency and non-agency mortgage backed securities from Held for Trading (HFT) to Available-for-Sale (AFS) effective August 1, 2008.

Loan Loss Provisions Increase

• Specific loan loss provisions (LLPs) increased to $474 million or 0.63% of loans from $334 million or 0.47% of loans in the previous quarter and $263 million or 0.42% of loans a year earlier. LLPs in Canadian Banking increased 6% to $225 million from $212 million a year earlier. LLPs in International Banking continue to rise, increasing to $198 million from $72 million a year earlier and up from $137 million in the previous quarter relating to U.S. residential builder finance.

• RY added $145 million ($98 million after-tax or $0.07 per share) to general reserves. Therefore total loan loss provisions were $619 million or 0.82% of loans.

• Loan loss provisions in fiscal 2008 were $1,450 million or 0.48% of loans versus $791 million of 0.32% of loans in fiscal 2007.

• We are increasing our 2009 and 2010 LLP estimates to $1,800 million or 0.58% of loans and $2,000 million or 0.62% of loans from $1,500 million or 0.51% of loans and $1,800 million or 0.59% of loans, respectively.

Loan Formations Increase

• Gross impaired loan formations increased to $1,091 million versus $753 million in the previous quarter and $573 million a year earlier. Net impaired loan formations increased to $1,192 million, up from $605 million in the previous quarter and $424 million a year earlier, reflecting mainly higher impaired loans in the U.S. residential builder finance portfolio.

Tier 1 Ratio Declines to 9.0%

• Tier 1 capital (Basel II) declined to 9.0% from 9.5% in the previous quarter due to 10% sequential increase in risk-weighted assets with 2/3 due to depreciation in the C$.

• The common equity to risk-weighted assets (CE/RWA) ratio was 10.1%, versus 10.4% in the previous quarter and 9.0% a year earlier.

Additional Disclosure on High-Risk Assets

• The bank provided additional disclosure on its exposure to U.S. sub-prime, auction rate securities, municipal GICs, CMBS, U.S. insurance and pension solutions, and U.S. MBS and other securities. The notional and fair value exposures to these areas as well as writedowns are detailed in Exhibit 2. We believe that RY has a good handle on exposure and that cumulative and potential writedowns are manageable.

Recommendation

• We are reducing our 2009 and 2010 earnings estimates to $4.20 per share and $4.80 per share from $4.70 per share and $5.20 per share, respectively.

• We maintain our 1-Sector Outperform rating on the shares of Royal Bank based on strength of franchise and operating platforms, particularly Retail Banking and Wealth Management, growth prospects from RBC Capital Markets, and higher than bank group ROE.

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Financial Post, Eoin Callan, 5 December 2008

Royal Bank of Canada's bank branches in the United States has turned into a money-losing enterprise, in a sign of how worsening economic conditions are starting to compound the damage being inflicted on banks by volatile financial markets.

Having pushed deep into southeastern states such as Florida and Alabama when local housing markets were soaring, Canada's largest bank now finds itself losing money amid plunging home prices and heavy job losses.

The reversal is only one of many headaches for chief executive Gord Nixon, who is also grappling with ongoing exposures to complex credit instruments and mortgage-backed securities that have already cost the bank $2.8-billion this year.

Yet the setback at the retail chain is significant because it suggests new sources of losses are arising for banks as market turmoil fuels an economic nosedive.

RBC predicts that financial "volatility will continue to dampen both consumer and business spending and will likely cause the U.S. recession to deepen."

The bank also suspects the Canadian economy has already slipped into a recession, while official figures Friday showed job losses were the worst in a quarter century last month.

This means Bay Street is likely to find more Canadians will struggle to pay back loans after years of record borrowing, which in turn means banks may be forced to set aside increasing amounts to cover credit losses.

This combination of investment losses and exposures to worsening credit conditions means bankers are increasingly resigned to tough times next year.

In its end-of-year update Friday, RBC declined to provided guidance on how its business would perform next year, choosing instead to guide investors toward a time horizon of three to five years from now.

With persistent uncertainty about how long it will take for world stock indices to settle and the wider economy to recover, RBC's chief executive said Friday his bank would rein in risky bets and shrink the balance sheet it uses to trade in international markets.

While this will do little to address RBC's already-substantial exposure to highly-impaired credit markets -- a major source of concern for investors -- it may help the bank preserve capital so it can better deal with losses lurking in its books.

This is a top priority for executives, who Friday confirmed RBC's reserves had fallen to the lowest level of any bank in the country after four quarters of falling profit and trading losses.

This means RBC has a thinner capital cushion than its peers to absorb future losses, which analysts said Friday were highly probable.

Mr. Nixon said the bank would manage its books "prudently" and pointed out the bank "earned over $4.5-billion for our shareholders in 2008," as analysts underlined the bank's ability to re-balance its reserves over time from incoming cash.

The bank also eased pressure on its capital base by taking advantage of looser accounting rules to shift almost $7-billion of assets out of its trading book.

• The challenges related to the closing of the BCE privatization are a potential positive for TD. If the transaction does not close, TD would likely reverse provisions taken in past quarters.

We maintain our Underperform rating as capital ratios are still at the low end of the peer group, U.S. lending exposures are second highest among Canadian banks and overhangs related to Alt-A securities and the bank's basis trade remain. TD's Q4/08 cash EPS of $1.37 had been pre-announced, as had core cash EPS of $1.22.

• The two largest items of note were a credit trading loss of $350 million after tax, which was largely offset by the reversal of a substantial part of the bank's reserve for Enron litigation charges ($323 million after tax). EPS would have been approximately $0.70 lower had the bank not reclassified some securities into its available for sale portfolio.

The better than expected GAAP earnings led to a Tier 1 ratio of 10.5% - well ahead of the 9.6% we were expecting and highest of the Canadian banks that have reported.

Loan losses of $219 million were ahead of our $203 million estimate. The increase from Q4/07 was driven by higher losses in cards (volume growth, higher loss rates and the expiry of a securitization), as well as lower recoveries and higher losses in the corporate lending portfolio.

Accounting rule changes helped CIBC, as expected.

• $6.4 billion in CLO and trust preferred securities were reclassified from trading to held-to-maturity, which avoided losses of $629 million.

• Management also took advantage of new fair value rules to value CLO holdings based partly on models rather than solely on broker quotes, which increased the fair value of those instruments by $310 million, even though the market value of the assets would have declined during the quarter.

• These changes in value are justifiable based on accounting standards but they mask a decline in the market value of assets during the quarter.

We continue to rate the stock as Sector Perform, which is the highest rating we have for a Canadian bank. For the next three to six months, CIBC's stock should benefit from (1) low exposure to U.S. credit, (2) lower exposure to corporate credit risk, and (3) a higher Tier 1 ratio than peers. Offsetting these positives is continued lackluster relative retail revenue growth (down 2% YoY) and, looking further out, we believe that a significant increase in unemployment (which is not happening right now in Canada) would be most negative for CIBC relative to Canadian banks.

• We have raised our 12-month price target by $2 to $53 per share to reflect the higher than anticipated book value.

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Scotia Capital, 5 December 2008

• CM reported a decline in cash operating earnings of 32% to $1.57 per share, in line. The decline in earnings was led by CIBC World Markets with a 59% drop and CIBC Retail Markets declining 10%. Retail Markets revenue and earnings momentum remain weak.

What It Means

• Reported earnings were $1.09 per share better than expected. Net charges were $0.48 per share less than expected due to large gain of $895 million on reduction of unfunded commitment on VFN (LEH).

• Book value per share declined 12% in fiscal 2008 to $29.40 per share.

CIBC was downgraded to a “sell” by Dundee Securities analyst John Aiken after the bank reported its quarterly results Thursday morning. While he does not believe CIBC will need to raise more common equity in the near term, the bank “may not be deploying capital in areas that will generate growth once some stability returns to its operating environment.”

Mr. Aiken also told clients that external uncertainty and the impact on CIBC’s on and off balance sheet items suggest the coming quarters are not a good time to hold the stock.

“Despite a weakened valuation and a very strong regulatory capital ratio, we are hard pressed to recommend CIBC’s stock as the fourth quarter demonstrated way too many moving parts to have any confidence in limiting future write-downs,” he said.

Mr. Aiken is looking for more clarity on the bank’s outlook for additional write-downs. While this could come from CIBC’s afternoon conference call, it will probably take better visibility on the structured credit markets, the analyst said. “No one is forecasting this to occur any time soon.”

CIBC’s positive tax adjustments helped offset damage from another quarter of write-downs. Meanwhile, its net loss of almost $400-million from structured credit activities was offset by a change in valuation methodology to internal modelling from relying on external, arguably liquidation, quotes, Mr. Aiken said. This provided a $300-million benefit, while a change in classification of certain securities allowed the bank to avoid recognizing fair value adjustments of more than $600-million.

“All told, the gross charges relating to the run-off business appeared to be more in the neighbourhood of $1.3-billion,” the analyst said, adding that “significant, material economic losses and write-downs are still a potential for CIBC, regardless of accounting treatment.”

His previous rating was "neutral," while his price target stands at $54.

National Bank reported its full Q4/08 operating results yesterday consistent with the Core Cash FD-EPS of C$1.36 they pre-announced on November 26, 2008.

ImpactSlightly Positive. Relative to expectations based on the pre-announced results, the operating details provided some relief around the underlying operating momentum. Credit trends are slipping, but appear manageable and the bank has a middle of the pack capital position at 9.44% Tier 1. The stock appears to be attractively valued on an operating basis, although the yet to be completed restructuring of the ABCP market remains a risk/overhang. On the view that the restructuring is ultimately successful, we see good upside on the name even on slightly lower earnings and reduced Target Price.

Details

Getting to an earnings run rate. In its pre-announcement, the bank reported an adjusted number of C$1.36 inclusive of approximately C$0.25 in gains related to AMF. Ex the gain, the number was below expectations (C$1.11) and suggested a below consensus run rate for 2009. However, the full release offered additional details that indicate the bank also incurred trading related losses on the order of C$61 million after-tax that could be considered one time in nature and an offset to the gain. All in, the trend looks closer to C$1.40+/-; more consistent with the otherwise decent operating trends.

Reasonable underlying operating trends. The quarter suggests continued modest progress here, consistent with our expectations with decent volume growth in P&C and good cost control delivering low single digit growth while Wealth was surprisingly strong at +17.5%. We continue to hold modest expectations for 2009, but management does seem to be moving forward against its initiatives.

ABCP remains THE risk. The proposed restructuring of the 3rd Party ABCP market in Canada remain a key risk around the stock. Efforts have been underway for over a year now, and several difficult hurdles have been cleared (i.e. legal challenges etc). However, the final paper work has yet to be completed. Management, and other proponents of the deal, suggest that progress is being made and they are confident that it will be completed (National is explicitly giving it a 95% probability), suggesting the latest delays are merely housekeeping issues. Our visibility is limited, but the turbulent market conditions and the challenges across a number of counter-parties involved suggest continued risks in our view.

The failure of the restructuring process would be a significant negative development for the stock in our view in terms of its likely impact on capital. We consider the sensitivities around the potential outcomes in Exhibit 1.

Q4/08 Segment Highlights

P&C Banking. The segment continues to make progress along the lines of our modest expectations. Net income growth of 4.4% came on the back of decent volume growth and well controlled expenses (NIX +0.3%). Credit costs are trending higher, coming in ahead of expectations on cards/personal loans. We continue to expect modest progress going forward as management implements its strategic initiatives to drive revenue in the context of a challenging operating environment.

Wealth Management. A surprisingly strong quarter with net income +17.5%, helped in part by the contribution from recent acquisitions in the mutual fund operations. The quarter was also helped by very good cost control. The segment will remain highly market sensitive, but structural changes (cost cutting, acquisitions etc) should provide some help over the coming year.

Financial Markets. The reported numbers indicate the segment was down -20.5% to C$70 million of net income. However, taking out C$45 million after-tax gain on AMF and adding back investment losses of C$61 million (including C$23 million in write-offs for exposure to Lehman Brothers, AIG and Washington Mutual) would result in C$86 million in net income; flat with last year.

Justification of Target Price

Reflecting lower earnings and a lower book value, as well as compressed valuation multiple, we have reduced our Target Price from C$62 to C$55.

Thursday, December 04, 2008

• Canadian banks and other financial services companies are being pressured to raise capital as we re-enter the "capital/arms race" to have the most and highest capital ratios regardless of what is the appropriate amount of financial leverage. We believe regulators and markets are destined to overreact.

• We expect some banks and managements will resist the "panic," others will "capitulate." We believe the mismanagement of global leverage came from the asset side of the balance sheet (primarily unregulated and misregulated), not the capital side. The risk weighting of AAA securities as prescribed by Basel, in our opinion, was not the problem; rather it was the ratings placed on these securities.

• In terms of Canadian bank capital levels we are seeing modest declines in Tier 1 ratios in the fiscal fourth quarter (Exhibit 1), although they remain very solid, generally above the 9% level. The fourth quarter was particularly difficult on Tier 1 ratios given the spike in risk weighted assets due primarily to the C$ depreciating 19% against the US$, as well as charges to OCI (Other Comprehensive Income) from mark-to-market on the Available for Sale Securities (AFS) portfolio due to major widening in corporate spreads (temporary impairment, holding to maturity).

• Canadian banks have excess capital capacity to issue Preferred Shares and Innovative Tier 1 capital that would increase Tier 1 ratios a further 140 bp. We believe the preferred share market is somewhat full at this time and Innovative Tier 1 is relatively expensive. However, over the next year we would expect issuance in these markets to bolster capital. We expect further Tier 1 capital build from internally generated capital in the 75-100 bp range. Thus we believe Tier 1 capital can be increased to over 10%, and perhaps to 11% over the next few years with some patience. Canadian banks' capital ratios have absorbed the October meltdown whereas international banks with a December 31 year end have not.

• Canadian banks' capital positions (without government assistance) remain very solid. However, if banks feel compelled to "battle for capital" at this stage, whether they need it or not, we have attached exhibits indicating what equity would be required to boost capital immediately via equity only in three scenarios: (1) 50 bp increase (Exhibit 2); (2) Tier 1 9.5% (Exhibit 3); (3) Tier 1 10.0% (Exhibit 3).

Wednesday, December 03, 2008

Core cash EPS of $0.94 were in line with our estimate of $0.93 and the $0.94 reported in Q4/07.

• GAAP EPS of $0.28 were negatively impacted by write downs relating to certain trading activities and valuation adjustments which had largely been pre-released.

• Provisions for credit losses of $207 million were 118% ahead of Q4/07, and 25-30% ahead of our expectations and Q3/08. Formations of new impaired loans were in line with Q3/08 and did not witness acceleration in the quarter. However, we expect formations to increase in 2009.

• The Tier 1 ratio of 9.3% was down 0.5% sequentially, in line with our expectations.

Management is targeting a 2009 EPS range of $3.26-$3.42, which is well-below what street estimates were going into the quarter ($3.94 per share).

• We believe that the cautious earnings outlook is a reflection of rapidly deteriorating global economies, which has negative implications for banks, particularly loan losses.

• Our 2009 EPS estimate going into the quarter was $3.45, and we have lowered it by $0.20 to reflect higher expected loan losses. We believe that the street's estimates will have to come down by a larger amount.

• We believe that Scotiabank is not as well positioned to outperform its peers from an operating perspective in 2009 compared to 2008, because: (1) We believe that structured finance/off-balance sheet conduit issues are likely to cause lower writeoffs for the bank's peers than in 2008. (2) We expect the credit cycle to broaden to areas beyond U.S. residential real estate/U.S. consumer/U.S. residential construction lending, into areas where Scotiabank has more exposure such as traditional business lending in the U.S., Canada, Latin America and the Caribbean. (3) The economic environment in Latin America has deteriorated rapidly, which has negative implications in our mind for both earnings risk and the bank's multiple relative to peers. (4) Capital ratios are likely to decline to the low end of the Big 6 bank range after the close of the acquisition of a stake in CI Financial.

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Dow Jones Newswire, 3 December 2008

Analysts applaud Bank of Nova Scotia for "creative" approach to raising capital by issuing equity to Sun Life Financial to fund stake in CI Financial Income Fund. But some say bank could still issue common equity to the public, if markets continue their move lower. Desjardins Securities says all Canadian banks will see decline in traditional sources of capital -- unrealized equity gains and surplus allowances -- amid a depressed earnings environment. Meanwhile, the bar for capital at banks has been raised, analyst says. Quality of capital also key, an issue to watch at Bank of Montreal and CIBC.

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Ther Globe and Mail, Tara Pekins, 3 December 2008

Bank of Nova Scotia is changing the way it will pay for its $2.3-billion stake in mutual fund firm CI Financial Income Fund in order to boost its capital levels.

Scotiabank announced back in early October that it would be paying $2.3-billion in cash to insurer Sun Life Financial to pick up its 37-per-cent stake in CI Financial. On Wednesday, Scotiabank announced that it plans to close that deal next week, but it will only hand over $1.55-billion in cash. The remainder of the purchase price will be paid for with $500-million worth of common shares and $250-million in preferred shares.

By preserving cash, the bank will bolster its capital levels, keeping more of a financial cushion that buffers it from unforeseen events.

The move “enables us to keep some capital available for future initiatives,” said Scotiabank spokesman Frank Switzer.

“What the deal does is adds $750-million to Scotiabank's regulatory capital, improving the bank's ratios,” Dundee Capital Markets analyst John Aiken wrote in a note to clients. “This will alleviate some of the concerns surrounding the bank's capitalization that arose out of its quarterly earnings released yesterday and should remove on of the pressures on its valuation.”

Scotiabank announced a 67-per-cent drop in fourth-quarter profit Tuesday, after being hit by a $642-million after-tax writedown.

While Scotiabank might still issue preferred shares to continue to shore up its capital ratios, there is no longer a sense of immediacy, Mr. Aiken wrote.

National Bank Financial analyst Robert Sedran said Scotiabank's Tier 1 capital ratio, the key measure that regulator's watch, had been expected to dip to 8.8 per cent if the deal for the stake in CI had been all-cash. With the changes, Scotiabank's Tier 1 ratio will now be about 9.1 per cent, he said. Regulators require the ratio, which is a measure of a bank's capital against its assets weighted by the risk they pose, to stay above 7 per cent.

Scotiabank said it will issue $500-million in common shares to Sun Life at $34.60 per share, and $250-million in 6.25 per cent rate reset preferred shares.

Scotiabank is purchasing the stake in CI Financial, which is the country's No. 3 mutual fund company by assets under management, to bolster its Canadian wealth management operations, which are a key priority for the bank.

Senior executives said the bank had stopped competing with Bay Street rivals to increase the bank's share of mortgages issued to Canadians.

"We lost a little bit of market share, and we've done that consciously," said Chris Hodgson, head of Canadian banking.

The disclosures indicate the bank has made a major strategic decision that separates it from Toronto-Dominion Bank. In particular, chief executive Ed Clark has promised investors he will dramatically increase the bank's share of the retail market.

The retreat by Scotia could leave the field open for TD and BMO to compete most aggressively to offer Canadians new loans, if RBC and CIBC follow Scotia's lead and ease back next year.

Rob Pitfield, the head of international banking at Scotia, said managers were also becoming "very circumspect" in providing consumer loans in Latin America and had "taken alot of action to tighten up."

In some respects, Scotia's executive team is putting into words what many bank executives around the world have been reluctant to say publicly, for fear of drawing political ire at a time when policymakers are encouraging financial institutions to ease the supply of credit.

The chief executive said interference from politicians was emerging as a major headache for international banks that had been compelled to turn to their governments for capital injections amid one of the worst financial crises of the century.

"I don't think government capital comes cheap," said Mr. Waugh, citing pressure on banks to make more loans to mitigate the impact of a recession.

"Politically, it comes with a true cost," he added, saying some foreign banks had been forced by governments to take capital they "didn't want" to guard against potential future losses.

Yet despite the warnings about the after-effects of state interventions, Scotia appears likely to be a beneficiary of moves by the Federal Reserve and United States Treasury to supply extra liqudity to the auto finance industry.

Scotia has more than $20-billion in exposures to the auto finance industry, mainly in the form of loans to consumers to buy cars and to auto dealers to keep their lots filled with vehicles.

The bank has extended about $5.2-billion in loans to consumers, parts manufacturers and dealers, plus exposures of $7.8-billion in off-balance sheet vehicles and another $7.8-billion in an on-balance sheet portfolios made up of securitized credit.

The exposures are a source of "concern" but have so far been managed without unexpected losses, said Peter Routledge, a senior credit officer at Moody's, the ratings agency. "If we have a normal turn in the credit cycle tied to a recessionary period, then that would suggest they would not have difficulties managing credit losses. If it is an unusually bad cycle and credit losses are much higher, than conceivably it might put some negative pressure on the [credit] rating," said Mr. Routledge.

Brian Porter, Scotia's chief risk officer and a rising force within the bank, said the next year "is going to be a focus on credit, credit and credit."

But he said while there would be a rise in loan losses across the board, he did not anticipate any nasty surprises.

The chief executive said Scotia would not raise capital by issuing common equity, but had ample scope to take advantage of new looser capital rules by selling preferred shares.

Analysts said they expected the bank to act soon to pad its capital base in this way, as its reserves appeared set to dip below the level of 9% of risk-weighted assets, a trigger for other institutions to raise cash.

Scotia Tuesday said profit fell 66% due to a worse-than-expected charge of $642-million incurred amid turbulent markets. The bank said net income for the quarter ended Oct. 31 was $315-million (28 cents) compared with $954-million (95 cents) in the year-earlier quarter.

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The Globe and Mail, Steve Ladurantaye, 3 December 2008

Bank of Nova Scotia shares were hit hard yesterday after the bank reported a 67-per-cent drop in fourth-quarter profit, with bad investments leading to a $642-million after-tax writedown.

"Clearly, 2008 was a difficult year, particularly with the writedowns we took in the fourth quarter," chief executive officer Rick Waugh said. "While Canadian banks have fared better than their counterparts in other parts of the world, none of us have been immune to the forces buffeting global markets."

The company's shares fell 7 per cent as analysts warned that the bank faces more difficulties, despite its relatively upbeat forecast and a prediction that it could increase earnings per share by up to 12 per cent in 2009.

"Surprisingly, BNS did provide targets for 2009, but we are taking them with a grain of salt, given that we see much more volatility in and less visibility for earnings in the upcoming year," said Dundee Securities Corp. analyst John Aiken, who reiterated his "sell" rating on the shares in a note to clients.

Profit was $315-million or 28 cents a share, compared with $954-million or 95 cents in the same quarter last year. Total revenue fell to $2.49-billion from $3.08-billion.

The $642-million writedown was 7.9 per cent higher than the $595-million charge the bank warned investors to expect when it prereleased earnings in late November. Without the writedown, Canada's third-largest bank said it would have earned 93 cents a share.

The bank's Scotia Capital division took the biggest hit in the fourth quarter, with profit down 80 per cent to $44-million from $229-million. International banking revenue was off 15 per cent, with profit at $227-million, down from $359-million a year ago.

However, the Canadian banking division saw profit increase by 6 per cent, helped by the acquisitions of Dundee Bank, Travelers Leasing, TradeFreedom and E*Trade Canada. Profit was $466-million in the division, up from $439-million last year.

"In 2009, we will be emphasizing two of our traditional strengths as key additional priorities: risk management and expense control," Mr. Waugh said. "These priorities will be key success factors in the current environment."

With the bank's shares closing at $32.38 on the Toronto Stock Exchange yesterday, they yield 6 per cent.

"Our dividend remains well supported by both our earnings and high capital levels, which remain strong by global standards," Mr. Waugh said.

Provisions in the quarter for credit losses of $207-million were 118 per cent higher than a year ago, reflecting the problems facing consumers and business as the economy has worsened.

"Management expects loan losses to be higher in 2009 but within risk tolerances," RBC Dominion Securities Inc. analyst André-Philippe Hardy wrote in a note. "Slowing economies and lower recoveries are likely to drive loan losses higher."

For the full year, the bank said it took $822-million in writedowns. Profit fell 22.5 per cent to $3.14-billion or $3.05 a share from $4.05-billion or $4.01 a share.

"The financial sector and the global economy will likely continue to experience significant uncertainty in 2009," Mr. Waugh said.

"However, Scotiabank's diversity - by business line, by product and by geography, including our presence in higher-growth emerging markets - leads us to anticipate moderate overall growth for the bank in 2009."

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Dow Jones Newswires, 2 December 2008

Turns out Bank of Nova Scotia is less bullish on 2009 than it first seemed. Some observers thought BNS was being aggressive with its outlook of 7%-12% earnings growth for a year in which North American economy's likely to sink. But CEO clarifies that growth rate based on reported EPS -- which includes C$822M in after-tax charges. That means F2009 EPS will be closer to C$3.35/share than the current C$3.94 mean estimate.

John Aiken at Dundee Securities is taking Bank of Nova Scotia's 2009 forecast with a "grain of salt." He sees "much more volatility in and less visibility for earnings" next year than BNS appears to. Key worry is credit quality weakening faster than expected, a theme also seen with Bank of Montreal. But BMO gave no 2009 guidance, citing uncertain outlook for markets. BNS also surprised with write-downs C$50M higher than when bank warned a few weeks back. That news seems to offset strong performance in domestic and investment banking units.

Expecting to suffer its first loss as a public company, Manulife Financial Corp. is reluctantly tapping the market for equity, the second Canadian financial institution to do so in as many weeks because of investor pressure to boost softening capital levels.

Chief executive officer Dominic D'Alessandro said in an interview yesterday the equity move is "not what I would have preferred to do, but like everybody else, when the facts change maybe it's an indication you should change your position."

The move will put Manulife in a position to not be left out of the race for acquisitions as the global life insurance industry goes through a round of consolidation.

Manulife is issuing at least $2.125-billion of common equity to raise its capital levels, which have been walloped because of the company's large exposure to stock markets.

It now expects to lose $1.5-billion in the fourth quarter, the first time it has not earned a profit since going public in 1999.

On a mid-October conference call, Mr. D'Alessandro told analysts that the insurer remained very well capitalized and "we have no intention to issue equity capital, contrary to speculation that came to our attention." Instead, Manulife went on to arrange a $3-billion loan from the big banks to bolster its financial cushion.

But stock markets continued to tank, eating away at the large investment portfolio that Manulife holds in its variable annuity and segregated funds business. As those investments sink, Manulife is required to put more money aside as capital. Its shareholders weren't satisfied.

"We thought the $3-billion facility that we put in place had allayed the concerns that were out there, but it didn't do the job," Mr. D'Alessandro said in yesterday's interview. "Our stock price kept suffering from weakness and we kept hearing from investors and other people close to the company that maybe we should just bite the bullet and put it behind us because no one knows how long these uncertain times are going to be with us."

The company would not have changed its tune if it were convinced that this was "a passing storm," he said. "But it may endure for a while and we don't want to be in a position where there are all kinds of things happening in our business and we're on the sidelines."

Shane Jones, managing director of Canadian equities at Scotia Cassels, which owns Manulife shares, said the company should have taken action sooner. "Now they've come to market at the bottom. If they had raised equity a month ago they would have done it at a better price."

Raising more equity will safeguard the insurer from further declines in stock markets as well as boost Mr. D'Alessandro's ability to snap up more assets before he leaves his post in May.

Manulife chief investment officer Don Guloien, who will replace Mr. D'Alessandro when he retires next year, has met with bankers to examine parts of American International Group Inc., sources have told The Globe and Mail. Manulife is also believed to be keeping an eye on U.S. rivals whose share prices have been battered by the financial crisis.

Last week, Toronto-Dominion Bank CEO Ed Clark decided to issue $1.4-billion of common equity, days after suggesting he would do no such thing. Like Mr. D'Alessandro, Mr. Clark also said he faced pressure from investors.

The sudden death of massive financial institutions such as Lehman Brothers has caused the market to attach a new importance to capital, which provides firms with a buffer in times of trouble. The capital ratios of all of Canada's largest banks and insurers have remained well above the minimum levels that regulators require, but that's no longer good enough.

Mr. D'Alessandro believes that the capital requirements for Canadian life insurers, dictated by the Office of the Superintendent of Financial Institutions, are still too strict. OSFI changed the rules in late October to give Manulife and its rivals more breathing room. But Manulife is still required to put aside large amounts of capital each time stock markets drop.

With the new equity, the insurer's capital ratio (called the MCCSR, or Minimum Continuing Capital and Surplus Requirements) will be about 235 per cent, one of the highest levels in the company's history. Manulife aims to keep the ratio between 180 and 200 per cent, and OSFI requires that it remain above 150 per cent.

Manulife will now pay back $1-billion of its bank loan and sell $1.125-billion of equity by way of a private placement to eight existing institutional investors such as the Caisse de dépôt et placement du Québec, the investment arms of big banks including Royal Bank of Canada and Toronto-Dominion Bank, and Jarislowsky Fraser Ltd. A further $1-billion is being sold to the public in a bought deal. The new equity is being issued at $19.40 a share.

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Financial Post, Eoin Callan, 3 December 2008

Manulife Financial is moving to shore up its capital base after falling into a loss for the first time in its history as a public company.

Canada's largest insurer will issue $2.125-billion in common equity at a discount after seeing its capital base eroded amid extreme volatility in financial markets.

The bid to raise cash underlines how the ongoing financial crisis is draining reserves from the country's financial system.

The insurer expects to lose $1.5-billion this quarter, as revenues decline and investments lose value in the face of a global economic slowdown.

A key reason for the poor performance is the need for the insurer to back stop losses on investments made to support financial products sold to Canadians and Americans that guaranteed minimum returns.

Manulife enthusiastically joined in an industry craze selling segregated funds or variable annuities to customers the promised them investment income as they prepared for old age.

But that business model has broken down amid the seize up in credit markets, and Manulife said on Tuesday it will be forced to set aside an extra $4.5-billion on Dec. 31 to cover these "guarantees".

This move comes even after Ottawa loosened accounting rules at the behest of the insurer, allowing it to set aside less reserves than under the old system.

The bid to raise capital is a climb down for the chief executive, who retires in the spring after 14 years and had insisted the company would not need to issue common equity.

The shares will be sold in a public offering at a heavy discount at $19.40 per share.

The share issue will include $1.125-billion sold by way of private placement to eight existing institutional investors and $1-billion to a syndicate of underwriters.

The move comes after the company signed an agreement to borrow $3-billion from the country's top banks only weeks ago.

That credit line will now be reduced to $2-billion.

Manulife shares are expected to slide at the open to close to $20 per share, according to analysts.

TD Bank Financial Group made a similar move to shore up its own capital position last week. TD said it was being forced to brave extremely volatile markets with a bid to raise up to $1.2-billion in cash, after coming under pressure from investors to take action over its shrinking capital base.

The TD action led one analyst to suggest Manulife also turn to equity the markets. John Reucassel, an analyst at BMO Capital Markets, said that TD had done the insurer a favour by testing the market and proving investors were willing to back share issues.

"We believe that this could provide Manulife with an opportunity to also raise equity and strengthen its capital position in the face of volatile equity markets," the analyst said in a note to clients.

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Reuters, Lynne Olver, 2 December 2008

Manulife Financial Corp explored various options to boost its capital levels before announcing a big equity issue on Tuesday, which it went ahead with partly to stay in the acquisition game, Chief Executive Dominic D'Alessandro said on Tuesday in an interview.

A C$3 billion ($2.4 billion) loan facility that Manulife arranged in early November was not sufficient to shore up capital when stock markets were getting increasingly volatile, D'Alessandro told Reuters, making it "prudent" to issue common shares. A preferred equity issue would have been too small, he added.

"We wanted to be in a strong position to participate in any of the restructuring activities that may happen," he said.

The credit crunch and ensuing financial crisis, which has walloped many insurance companies' stock prices, has made Manulife the largest insurer in North America. It may also be the catalyst for consolidation of the fragmented U.S. industry, he said.

"Had we not done this issue, we might have been constrained in what we could look at or what we could entertain."

Earlier on Tuesday, the company said it would raise C$2.1 billion by issuing common stock at a price of C$19.40 a share.

The stock closed at C$19.89 a share, down 2.8 percent.

The CEO said he regrets having to issue shares, but that most people understood the company's dilemma -- as stock markets fall, it is forced to set aside more money to cover future obligations to certain policyholders.

"I'd like to say I'd rather have cut off a leg than issue equity at these prices, but on the other hand, we are where we are and the markets remain very volatile," D'Alessandro said, referring to Monday's steep stock-market plunges.

"You saw what happened yesterday, and you have to adjust your thinking for events as they unfold."

D'Alessandro said on a conference call in mid-October that Manulife was not contemplating an equity issue.

At that time, "we were feeling that maybe the worst of the storm was already upon us," he said.

"The events since October have been, if anything, even more dramatic. It's a case of changed circumstances. If I had my druthers, I'd rather not issue equity at these prices."

Manulife sold C$1.125 billion of shares by way of private placement to eight existing institutional investors and C$1 billion to a syndicate of underwriters in a "bought deal" public offering, both led by Scotia Capital Inc.

The company also said it expects to report a fourth-quarter loss of C$1.5 billion ($1.2 billion) due to the effects of falling stock markets.